Refinancing rental houses or other investment property comes with its own challenges, and today's tough mortgage environment makes it tougher than it used to be.
If you have a rental property, you may want to contemplate a refinance to improve your cash flow or to reduce your interest expense. Here are some important considerations you will need to work out before you refinance your investment property.
Refinancing for Cash Flow
In a tough economy, tenants have more leverage to demand lower rents, so landlords may need to lower their mortgage payments to avoid an out-of-pocket expense each month. There are several ways a mortgage refinance can accomplish this.
First, by stretching your current balance over a new loan term, you may be able to lower your monthly payments significantly, depending on how long you have been making payments on your current mortgage.
For example, if you took out a $300,000 mortgage at 6.625% five years ago, your monthly payment (principal and interest) would be $1,921; your remaining balance would be $281,233. If you refinanced that loan today for the same rate, yet started a new 30-year term, your payment would drop to $1,801, a reduction of $120. (You can see this yourself by easily plugging the figures into HSH.com's mortgage calculator.)
You can reduce your monthly payment even more by opting for a longer loan term, such as 40 years (Fannie Mae allows this for an additional 0.125% fee). However, you must remember that the longer the term, the more you pay more in total interest. Yet by stretching the balance in the above example over 40 years, your monthly payment drops to $1,672.
Finally, Fannie Mae allows borrowers to attach a 40-year term or interest-only option to hybrid adjustable-rate mortgage (ARM) products like 3/1, 5/1, or 7/1 loans. These hybrid ARM mortgages generally carry lower interest rates. If you can get a 5/1 ARM at 5.75% with a 40-year term, your payment becomes $1,499 ($422 lower than your original loan). That drop in your monthly payment can offset a pretty large rent reduction. Yet, you have to be prepared for the possibility that your mortgage payment could rise sharply after the ARM's fixed-rate period expires.
Refinancing for Savings
Another reason for refinancing an investment property is to save on interest paid over the life of the loan, and perhaps be mortgage-free as part of a retirement plan. For example, if you're 50 years old and plan to retire at age 65, you may want to refinance your investment property to a 15-year term. Refinancing to the shorter term in the above-mentioned example would get you a lower interest rate (about 0.5% lower, according to HSH.com's current mortgage rates) and would allow you to pay off the home loan around the time you stop working. At that point you can enjoy the rental income without the mortgage obligation.
The downside of this strategy is that you don't get a tax deduction for the extra principal payment, so you would be sacrificing cash flow today for wealth tomorrow.
Other Refinancing Considerations
Many homeowners acquire an investment property by purchasing it first as a primary residence, then converting it to a rental when they buy a new home for personal use. If your rental property's mortgage was last financed when it was your home, you may not be able to improve on the interest rate that you have.
Mortgage interest rates for investment property are considerably higher than those of primary or second homes. Fannie Mae's Loan-Level Pricing Adjustment matrix adds an investment property surcharge that ranges from 1.75% of the loan amount for mortgages of no more than 60% of the property value to 3.75% for 80% loans. That translates to a rate increase of 0.5% to over 1%. HSH.com's national average mortgage rates for 30-year home loans are close to 5.5%. Add another half point or so, and your current mortgage rate may look pretty good.
If your property has lost value -- as many have in today's challenging real estate market -- you may not be able to refinance it at all. Mortgage insurers have almost completely stopped backing investment properties, so you'll need at least 20% equity to get approved for a mortgage refinance.
Income qualifying is another obstacle in today's market. Unless your personal income is sufficient to absorb potential losses on the rental property, the property will have to pretty much pay for itself. If you originally financed it as a primary residence, the income from the property wasn't a consideration. But now, you'll have to document the property's cash flow with your tax returns. If it hasn't been rented out long enough for you to have a Schedule E, mortgage underwriters will credit you with 75% of the rent (you'll have to provide signed rental agreements and proof that the rent has been paid), or an appraiser may be asked to create a rental schedule showing what the property should rent for.
Finally, your lender will probably require you to sign a rider assigning rent to it if you default on your mortgage payments. That's to prevent you from collecting rent but withholding mortgage payments. While refinancing investment property has become even more difficult amidst current market conditions, it is certainly still possible if you're properly qualified.
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.
